Using Life Insurance for Estate Planning

The following is a guest post from Joel Ohman at Insurance Providers. Joel is a Certified Financial Planner™ and somewhat of an Internet nerd/serial entrepreneur depending upon who you ask.

One of the best tools that estate planning attorneys, financial planners, and CPA's have at their disposal for estate planning is life insurance. Estate plans big and small, complex to simple, and extraordinary to typical almost always involve some form of life insurance policy to complete the estate plan. Here are some of various things to understand about using life insurance in the estate planning process as well as tips for what type of strategies you may want to investigate further when crafting your estate plan.

One Common Misconception About Life Insurance

Before diving into some of the various ways that life insurance is used in estate planning it is worth pointing out a not insignificant issue that involves life insurance and estate taxes.

"The great thing about life insurance is that the death benefit that is paid out is tax free!" - have you ever heard that statement before? Many people say it and if you have ever listened to a sales pitch from a life insurance agent then no doubt covering the tax advantages of life insurance was one of their key talking points.

However, many people do not realize that the above statement is not necessarily true. The great thing about life insurance is that the death benefit is paid out income tax free and not necessarily tax free altogether as life insurance proceeds are typically included into the gross estate of the decedent (the deceased) and are thus subject to estate taxes (sometimes called "death taxes").

In a Nutshell: Why Use Life Insurance for Estate Planning?

If you get nothing else from this article then please understand this one thing: the reason why life insurance is so valuable as an estate planning tool is that life insurance allows one to guarantee that a lump sum of money will be available upon their death to be directed in a way that will provide maximum benefit to their estate. This is just a fancy way of saying that many very wealthy people have a lot of their wealth tied up in non liquid assets like houses, property, businesses, etc. that if their estate was forced to liquidate some or all of those assets at death then they would likely greatly inconvenience the beneficiaries of the estate at best or at worst force a very unwise business decision (selling a business before the ideal time, being forced to quickly sell a piece of land, etc. - all in order to pay estate taxes due). Using life insurance in estate planning gives enormous freedom to those who upon their death may be ultra wealthy but relatively cash poor.

Life Insurance Estate Planning Strategy #1: Credit Shelter Trust

The first very practical way to use life insurance in estate planning that we will take a look at is the credit shelter trust (also known as a "by-pass" trust or "exemption" trust). The purpose of the credit shelter trust is to fully utilize the estate tax unified credit to which both spouses are entitled. Practically speaking, this is how it works:

Estate tax law seems to always be up in the air and of course consult a qualified tax adviser for any specifics but just for example's sake let's say that a husband and wife combined have assets of $5,000,000 and the estate tax unified credit is constant at $1,000,000. If the husband were to die first and leave all of the assets to his wife then there would be no estate taxes due because of the unlimited marital transfer rule. However, if the wife died later on not having remarried and having assets of $5,000,000 then she would be forced to pay estate tax on $4,000,000 after the $1,000,000 unified tax credit. Wait! You say - if only we could have used the husband's unified tax credit as well then we could have only had to pay taxes on $3,000,000 rather than $4,000,000. That is where the credit shelter trust comes into play.

The credit shelter trust is a testamentary trust ("testamentary" meaning it is created and funded upon death through the decedent's will and is not an "inter vivos" trust that is created and funded while the trust grantor is still alive) that is funded typically with life insurance proceeds (although it can be funded with some other type of liquid assets) from a life insurance policy that is held on the trust grantor so that when the trust grantor dies the credit shelter trust is funded with an amount equal to the unified tax credit. The money contributed to the credit shelter trust is not subject to estate taxes because the amount contributed is equal to the unified tax credit, the corpus of the trust can be used to kick off income to pay to the spouse while still keeping the corpus of the trust excluded from the second spouse to die's estate.

Life Insurance Estate Planning Strategy #2: QTIP Trust

The QTIP trust (Qualified Terminal Interest Property trust) is designed to allow a decedent "control beyond the grave" of their assets without surrendering control of those assets to their surviving spouse - and at the same time allowing for the estate to take advantage of the marital deduction for the assets used to fund the QTIP.

Practically speaking, a QTIP is most commonly used in cases where one spouse is significantly older than the other spouse and/or there are kids from multiple marriages in the picture. A QTIP trust will allow the older spouse that passes away first to make sure that their surviving spouse receives all of the income from the trust (the surviving spouse gets all of the income while alive and is also allowed to dip into the trust principal only to meet their MESH needs: Maintenance, Education, Support, or Health - no, no, no - the surviving spouse won't be able to rack up a ton of credit card debt with a new love interest and expect the QTIP to pay off the credit cards) while at the same time preserving all of the corpus of the trust to be distributed to the children of the first spouse to die (rather than the pool boy that the surviving spouse may choose to remarry, children from a second marriage, etc.).

Life insurance is of course a great vehicle to fund a QTIP trust. One important detail to note about the QTIP is that unlike the credit shelter trust the assets in the QTIP will be included in the surviving spouses federal gross estate (this is why many estate planning attorneys will get paid the big bucks to recommend intricate strategies that involve both a credit shelter trust, a QTIP trust, and potentially many other types of trust in combination.

Life Insurance Estate Planning Strategy #3: Irrevocable Life Insurance Trust

The ILIT or irrevocable life insurance trust is an inter vivos trust (as opposed to both the credit shelter trust and the QTIP trust which are both testamentary trusts) and is designed with a very simple purpose in mind: the ILIT owns a life insurance policy on the life of the trust grantor so that the death benefit proceeds from the life insurance policy will not be included in the federal gross estate of the insured upon their death.

As mentioned above under the "common life insurance misconception" header almost all life insurance death benefit proceeds are included in the federal gross estate of the insured. The reason why it is included in the federal gross estate is because when tabulating the decedent's estate one must include all assets where the decedent had any "incidents of ownership". Typically the decedent owns the life insurance policy on their own life and has the power to make changes to the policy which counts as an incident of ownership. The ILIT avoids this incident of ownership by letting the grantor irrevocably assign away ownership of the life insurance policy to the ILIT.

What do YOU Think?

What is YOUR take on using life insurance for estate planning?

Comments

[Apex]

The obvious key to whether life insurance proceeds are included in the federal gross estate is who owns the policy. You mentioned the ILIT as a way to get the ownership out of the estate (for my future purpose this is likely to be the only reason I would consider estate based life insurance so the ownership issue is the critical one to me).

So I have a couple questions for you.

What is so special about the ILIT that allows the trust grantor to setup the life insurance policy but not be considered the owner? Does he lose all rights to make changes to it? Who has ownership rights over this policy? Obviously the ILIT does but does that mean the beneficiaries of the ILIT control the policy or is it just a simple slight of hand that allows the trust grantor to still control the policy but have it treated like he didn't? Some further explanation of the details of how this works and why it keeps it out of the estate from an ownership standpoint would be helpful.

Second, why is this all necessary? Why couldn't you just put the ownership of the policy in the names of the beneficiaries? Can you do that and still pay the premiums or does the owner have to make the premium payments on it to be consider the owner?

Thanks.

[jeffinwesternWA]

About time somewhere on this site the benefits of LI, especilly permanent policies like WL, UL, etc., virtues are seen! Those who don't have much or won't buy some term for NEEDS protection and move on, others take note, especially as the govt(s) raise taxes in the upcoming decade!

[MasterPo]

Jeff - Don't be surprised if life insurance proceeds become taxable as income too.

[Ed]

Apex - an ILIT is an irrevocable trust in that the grantor will fund the trust with moneys, which is deemed to be a transfer for gift tax purposes, utilizing a portion of the grantor's lifetime exemption. This gets funds out of the decendent's estate. The trust then uses those funds to purchase a policy.

[Apex]

@Ed,

Ah, it uses the gift exemption. That is not nearly as valuable then, because the gift exemption (not the annual one but the lifetime one) comes off your lifetime estate exemption so if you are trying to keep money out of your estate for taxes purposes this doesn't really work, unless you die early and the life insurance pays out far more than you put in the ILIT for gift purposes. But if the goal is to pay a bunch of premiums now to get a death benefit to someone else tax free (even estate tax free) then it seems like this tactic isn't really that great of one.

I still think just putting life insurance in your beneficiaries name is likely as good a way to go as any (assuming they can be trusted not to cash them in). Then you just pay the premiums for them and use that to get the money out of your estate. If you can't do that for tax purposes and have them counted as the owner (still waiting for an answer on that), then you could use the 13,000 annual gift exemption to give them the money for the premium because this doesn't come off the lifetime estate tax exemption. Of course you could just gift them money and put it in a trust in their name to keep them from accessing it and invest it as well.

I am still waiting for the silver bullet showing life insurance to be a huge boon for estate tax planning. Haven't seen it laid out yet. I would really like to see someone lay out the way it which it is so much better but, it seems like every time I see something that looks promising it turns out to be less than meets the eye, just like this ILIT now looks given that it has to be funded with the gift tax exemption which reduces the lifetime estate tax exemption.

[Aaron @ Clarifinancial]

Apex, to build on what Ed said, the trust owns the policy. The Uniform Prudent Investor Act states that the trustee must manage trusts for the benefit of the trust beneficiaries. So the word "irrevocable" is very important when describing this type of life insurance trust.

Your second question is very good one. Keeping the value of the policy in the trust keeps it out of the estate of the beneficiaries (who may also be impacted by its size), and trusts allow a finer level of control over contingencies and conditions at the beginning than outright ownership. Find a qualified attorney in your area for more info.

[jim]

Is the primary benefit of all this really aimed at avoiding estate taxes?

Estate taxes have very high exemption level and generally only apply to multi-millionaires. So does any of this really apply to people who aren't multi-millionaires?

[Apex]

@Jim,

You are correct, avoiding estate taxes does not apply to people who aren't millionaires.

Currently the exemption was last 3.5 million (estate taxes went away entirely in 2010). However they are scheduled to return in 2011 and the exemption is schedule to return back to 1 million. It's possible that will be raised before it returns, but given the fights going on in Congress, I wouldn't count on it.

For those who are saving for retirement and following the advice given here, the 1 million dollar exemption level is very relevant for a lot of readers by the time they are 70 or 80.

If you won't be at over a million then it won't matter to you. But as has been said many times here before, a million aint what it used to be (even though I understand it's a lot more than most have).

[Ed]

Outside of the estate tax benefit is the ability to really control what happens to your estate when you pass. Who gets what. How much they will get. What they can do with it. And life insurance really gives you the ability to do that in many situations.

There are many many many creative things one can do with life insurance in a trust setting. One thing I will say however is that many of the attorneys that sell the policys that fund many of the estate plans out there rake up a ton off of the insurance premiums. This stuff can get really complex so unless you understand every little bit of it, do not ANYTHING until you do. I have seen too many people end up with far too complex estate plans than they would ever really need all because an attorney wanted to sell some premiums.

[jeffinwesternwa]

If the attorney is licened LI agent, AVOID, I've rarely seen it as a FP of 16+ years though...

[Ed]

Apex - just to comment on your remark that it would not accomplish getting funds out of a taxable estate because it uses your lifetime exemption; it does get funds out of your estate equal to the life insurance proceeds.

I.e. If you have a $5 million taxable estate at death and no exemptions left and all of it was taxable at the time of death, you can get all 5 million to your heirs simply by setting up a trust, and the trust buys a 5 million policy. When you die, the 5 million in your estate would be subject to estate tax, say at 50%, so after tax, there would be 2.5 left for heirs, but then the trust, which would be the beneficiary would receive 5 million in insurance proceeds tax free...... Then your heirs end up with 7.5 million. 2.5 from the taxable estate, and 5 million sitting in trust.

[Apex]

@Ed,

You seem to be of the opinion that you can buy 5 million in life insurance for no cost. If I have a 5 million estate and still have that plus a 5 million dollar life insurance policy when I die, what funded the policy? Keep in mind insurance companies have to make more than they pay out or they go broke. It's not remotely accurate to suggest I can just get an extra 5 million to my heirs and have it not affect my other estate assets. Unless I die in the first few years, it will have huge impacts on my other estate assets.

So if I buy a 5 million dollar policy when I am 65 lets say and then I live to lets say 85. I will have paid a whole lot of premiums in that time. The average buyer must pay enough in premiums to cover the full 5 million dollar pay out when the insurance company takes their premiums plus any earnings they can make off them minus their overhead expenses, sales commissions and profit, which means they likely have to get atleast 6 million on average (premiums + earnings) to pay out the 5 million. In the current interest rate environment the vast majority of that 6 million has to come from premiums because there won't be lots of earnings. So as I stated earlier, unless you die early (don't think anyone is hoping for that), I still don't see how it accomplishes much. I will have paid a large portion of my estate out to pay for the 5 million in life insurance coverage. And if I live to a really old age, depending on the type of policy, I could pay out considerably more than I get back.

So I am still looking for how this is such a great way to get out of taxes. I want there to be a good way to do this and as of yet everyone still proposes ideas that sort of might save you money under some circumstances but it's not the "deal" it's often sold to be. I would love someone to show a rundown with numbers of how it saves so much money by doing this, with some real numbers that account for premiums and impacts on estate tax exemptions.

[jim]

"Outside of the estate tax benefit is the ability to really control what happens to your estate when you pass. Who gets what. How much they will get. What they can do with it."

Generally I think its the will and/or trust that actually controls who gets what. I wouldn't see insurance as being a requirement for that.

[Tools Insurance]

You seem to be of the opinion that you can buy 5 million in life insurance for no cost.Then you just pay the premiums for them and use that to get the money out of your estate. If you can't do that for tax purposes and have them counted as the owner (still waiting for an answer on that), then you could use the 13,000 annual gift exemption to give them the money for the premium because this doesn't come off the lifetime estate tax exemption For those who are saving for retirement and following the advice given here, the 1 million dollar exemption level is very relevant for a lot of readers by the time they are 70 or 80.

[300]

Apex -an ILIT is an irreversible trust in that the grantor will fund the trust with moneys, which is believed to be a transfer for gift tax purposes, using a portion of the grantor's lifetime indemnity. This gets funds out of the decedent’s estate.